Forget rates! Weak earnings, wobbly economy signal a correction - A.Mahmudova

Stock market pundits say the six-year-old bull market is due for a correction of at least 10% soon.

The market, which staged a monster rally in stocks on Wednesday, as the Federal Reserve signaled that it plans on adopting a cautious approach to hiking rates for the first time in nearly a decade. The Fed policy stance also sent the dollar to its largest one-day percentage drop versus the euro since March 18, 2009.

But a genuine shake-up in the market, particularly in stock values, isn’t hard to imagine, if you think about it. For one, market fundamentals aren’t as sanguine as they were once thought and stock valuations are getting downright rich. The lofty valuations didn’t go unnoticed by the Fed Chairwoman Janet Yellen either as the central bank walks a delicate balance of weaning the market off the ultralow borrowing costs to which it has grown accustomed.

The benchmark S&P  500 enjoyed tremendous expansion in price-to-earnings ratios. Translation: Stocks that were already fairly valued based on their P/E ratios have gotten more expensive over the past few years. Experts have attributed the so-called multiple expansion, as it is termed in the world of stock investing, to the Federal Reserve’s monetary stimulus and expectations that the economy will stage an unfettered recovery.

But since the Federal Reserve ended its quantitative-easing program in October last year, markets have been a bit unhinged, including wild moves in commodity and currency markets, notably in oil, the dollar and the euro.

Moves in oil and the dollar have had severe ramification on future earnings — Wall Street’s estimates have been lowered dramatically, which in turn has sent P/E ratios even higher.

On the consumer side, retail sales show that Americans are still struggling, even with a little bit of extra cash from lower gasoline prices. Even the job growth report, showing more than 200,000 new jobs a month were created, has been tainted with record low participation rates and near-stagnant wages.

Chief global strategist at Société Générale, Albert Edwards, a notorious bear has recently warned of an impending recession.

In a recent note to investors, the SocGen economist warned of a bubble forming in the stock market and once it bursts, the economy will tumble into a recession before the Fed’s tightening policy will take hold.

Even if the economy continues to grow at the same or a slightly faster pace than 2014, high valuations in the face of falling earnings put the market at risk for tipping over.